Material Type:
Module
Provider:
Rice University
Tags:
Corporate Income Tax, Estate and Gift Tax, Excise Taxes, Individual Income Tax, Marginal Tax Rate, Payroll Tax, Progressive Tax, Proportional Tax, Regressive Tax
Language:
English

Taxation

Lesson Overview

By the end of this section, you will be able to:

  • Differentiate among a regressive tax, a proportional tax, and a progressive tax
  • Identify major revenue sources for the U.S. federal budget

Section 1

There are two main categories of taxes: those that the federal government collects and those that the state and local governments collect. What percentage the government collects and for what it uses that revenue varies greatly. The following sections will briefly explain the taxation system in the United States.

Section 2: Federal Taxes

Just as many Americans erroneously think that federal spending has grown considerably, many also believe that taxes have increased substantially. The top line of Figure shows total federal taxes as a share of GDP since 1960. Although the line rises and falls, it typically remains within the range of 17% to 20% of GDP, except for 2009, when taxes fell substantially below this level, due to recession.

The graph shows five lines that represent federal taxes (as a percentage of GDP). Total federal tax receipts was around 17% in 1960 and dropped to around 17.5% in 2014. Individual income taxes were consistently between 7% and 10%, but rose to 8% in 2014. Payroll taxes rose from under 5% in 1960 to around 6% in the 1980s. It has remained virtually consistent since then. Corporate income taxes has always remained below 5%. Excise taxes were highest in 1960 at around 2%; in 2009, it was less than 1%.
Federal Taxes, 1960–2014 Federal tax revenues have been about 17–20% of GDP during most periods in recent decades. The primary sources of federal taxes are individual income taxes and the payroll taxes that finance Social Security and Medicare. Corporate income taxes and social insurance taxes provide smaller shares of revenue. (Source: Economic Report of the President, 2015. Table B-21, https://www.whitehouse.gov/administration/eop/cea/economic-report-of-the-President/2015)

Figure also shows the taxation patterns for the main categories that the federal government taxes: individual income taxes, corporate income taxes, and social insurance and retirement receipts. When most people think of federal government taxes, the first tax that comes to mind is the individual income tax that is due every year on April 15 (or the first business day after). The personal income tax is the largest single source of federal government revenue, but it still represents less than half of federal tax revenue.

The second largest source of federal revenue is the payroll tax (captured in social insurance and retirement receipts), which provides funds for Social Security and Medicare. Payroll taxes have increased steadily over time. Together, the personal income tax and the payroll tax accounted for about 80% of federal tax revenues in 2014. Although personal income tax revenues account for more total revenue than the payroll tax, nearly three-quarters of households pay more in payroll taxes than in income taxes.

The income tax is a progressive tax, which means that the tax rates increase as a household’s income increases. Taxes also vary with marital status, family size, and other factors. The marginal tax rates (the tax due on all yearly income) for a single taxpayer range from 10% to 35%, depending on income, as the following Clear It Up feature explains.

How does the marginal rate work?

Suppose that a single taxpayer’s income is $35,000 per year. Also suppose that income from $0 to $9,075 is taxed at 10%, income from $9,075 to $36,900 is taxed at 15%, and, finally, income from $36,900 and beyond is taxed at 25%. Since this person earns $35,000, their marginal tax rate is 15%.

The key fact here is that the federal income tax is designed so that tax rates increase as income increases, up to a certain level. The payroll taxes that support Social Security and Medicare are designed in a different way. First, the payroll taxes for Social Security are imposed at a rate of 12.4% up to a certain wage limit, set at $118,500 in 2015. Medicare, on the other hand, pays for elderly healthcare, and is fixed at 2.9%, with no upper ceiling.

In both cases, the employer and the employee split the payroll taxes. An employee only sees 6.2% deducted from his or her paycheck for Social Security, and 1.45% from Medicare. However, as economists are quick to point out, the employer’s half of the taxes are probably passed along to the employees in the form of lower wages, so in reality, the worker pays all of the payroll taxes.

We also call the Medicare payroll tax a proportional tax; that is, a flat percentage of all wages earned. The Social Security payroll tax is proportional up to the wage limit, but above that level it becomes a regressive tax, meaning that people with higher incomes pay a smaller share of their income in tax.

The third-largest source of federal tax revenue, as Figure shows is the corporate income tax. The common name for corporate income is “profits.” Over time, corporate income tax receipts have declined as a share of GDP, from about 4% in the 1960s to an average of 1% to 2% of GDP in the first decade of the 2000s.

The federal government has a few other, smaller sources of revenue. It imposes an excise tax—that is, a tax on a particular good—on gasoline, tobacco, and alcohol. As a share of GDP, the amount the government collects from these taxes has stayed nearly constant over time, from about 2% of GDP in the 1960s to roughly 3% by 2014, according to the nonpartisan Congressional Budget Office. The government also imposes an estate and gift tax on people who pass large amounts of assets to the next generation—either after death or during life in the form of gifts. These estate and gift taxes collected about 0.2% of GDP in the first decade of the 2000s. By a quirk of legislation, the government repealed the estate and gift tax in 2010, but reinstated it in 2011. Other federal taxes, which are also relatively small in magnitude, include tariffs the government collects on imported goods and charges for inspections of goods entering the country.

Section 3: State and Local Taxes

At the state and local level, taxes have been rising as a share of GDP over the last few decades to match the gradual rise in spending, as Figure illustrates. The main revenue sources for state and local governments are sales taxes, property taxes, and revenue passed along from the federal government, but many state and local governments also levy personal and corporate income taxes, as well as impose a wide variety of fees and charges. The specific sources of tax revenue vary widely across state and local governments. Some states rely more on property taxes, some on sales taxes, some on income taxes, and some more on revenues from the federal government.

The graph shows that total state and local revenue (as a percentage of GDP) was less than 8% in 1960. It has decreased a bit since 2013.
State and Local Tax Revenue as a Share of GDP, 1960–2014 State and local tax revenues have increased to match the rise in state and local spending. (Source: Economic Report of the President, 2015. Table B-21, https://www.whitehouse.gov/administration/eop/cea/economic-report-of-the-President/2015)

Section 4: Key Concepts and Summary

The two main federal taxes are individual income taxes and payroll taxes that provide funds for Social Security and Medicare; these taxes together account for more than 80% of federal revenues. Other federal taxes include the corporate income tax, excise taxes on alcohol, gasoline and tobacco, and the estate and gift tax. A progressive tax is one, like the federal income tax, where those with higher incomes pay a higher share of taxes out of their income than those with lower incomes. A proportional tax is one, like the payroll tax for Medicare, where everyone pays the same share of taxes regardless of income level. A regressive tax is one, like the payroll tax (above a certain threshold) that supports Social Security, where those with high income pay a lower share of income in taxes than those with lower incomes.

Section 5: Self-Check Questions

Suppose that gifts were taxed at a rate of 10% for amounts up to $100,000 and 20% for anything over that amount. Would this tax be regressive or progressive?

Hint:

Progressive. People who give larger gifts subject to the higher tax rate would typically have larger incomes as well.

If an individual owns a corporation for which he is the only employee, which different types of federal tax will he have to pay?

Hint:

Corporate income tax on his profits, individual income tax on his salary, and payroll tax taken out of the wages he pays himself.

What taxes would an individual pay if he were self-employed and the business is not incorporated?

Hint:

individual income taxes

The social security tax is 6.2% on employees’ income earned below $113,000. Is this tax progressive, regressive or proportional?

Hint:

The tax is regressive because wealthy income earners are not taxed at all on income above $113,000. As a percent of total income, the social security tax hits lower income earners harder than wealthier individuals.

Section 6: Review Questions

What are the main categories of U.S. federal government taxes?

What is the difference between a progressive tax, a proportional tax, and a regressive tax?

Section 7: Critical Thinking Questions

Excise taxes on tobacco and alcohol and state sales taxes are often criticized for being regressive. Although everyone pays the same rate regardless of income, why might this be so?

What is the benefit of having state and local taxes on income instead of collecting all such taxes at the federal level?

Section 8: References

Burman, Leonard E., and Joel Selmrod. Taxes in America: What Everyone Needs to Know. New York: Oxford University Press, 2012.

Hall, Robert E., and Alvin Rabushka. The Flat Tax (Hoover Classics). Stanford: Hoover Institution Press, 2007.

Kliff, Sarah. “How Congress Paid for Obamacare (in Two Charts).” The Washington Post: WonkBlog (blog), August 30, 2012. http://www.washingtonpost.com/blogs/wonkblog/wp/2012/08/30/how-congress-paid-for-obamacare-in-two-charts/.

Matthews, Dylan. “America’s Taxes are the Most Progressive in the World. Its Government is Among the Least.” The Washington Post: WonkBlog (blog). April 5, 2013. http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/05/americas-taxes-are-the-most-progressive-in-the-world-its-government-is-among-the-least/.